Remarks at the SIA Soft Dollars and Institutional Brokerage Conference

Robert R. Glauber

Chairman and CEO

New York, NY
September 19, 2005

Good afternoon.  Thank you, Don [Kittell, SIA Exec. VP], for the introduction.  I am, as always, grateful to the SIA for inviting me to speak.  While our two organizations don't always agree, NASD has always afforded the SIA a special degree of access and cooperation, and we believe this can continue to engender a productive relationship.

We've made a lot of progress in the last couple of years toward erasing the investor suspicion and pessimism that set in after the recent melt-downs in corporate governance, the deflation of the Internet bubble and the so-called mutual fund scandals.  And by "we," I mean the industry as well as the regulators.

Moreover, the investor exodus from mutual funds that some feared would happen after the market-timing and late-trading debacle reared its ugly head never occurred.  The combined assets of American mutual funds have steadily increased with virtually no abatement to nearly $8.5 trillion today.

Ironically, what we may see instead is a broker migration from mutual funds now that the process of selling them is complicated by new sales practice requirements.  I have in mind a way to avoid that, which I'll talk about in a few minutes.

First, I'd like to bring you up to date on some mutual fund sales practice rules that we've proposed having to do with point-of-sale disclosure, revenue-sharing in the context of point-of-sale disclosure, soft dollars and breakpoints.  All these proposals were inspired, in whole or in part, by the findings of the NASD Mutual Fund Task Force, which we put together in the spring of 2004 to find ways to improve transparency in portfolio transaction costs and distribution arrangements.

And all of them share a common theme: disclosure, disclosure, disclosure.  Clear, intelligible and frank disclosure of information the investor needs to know is the keystone of investor protection.  But here I do want to emphasize clear and intelligible.  Sufficient information, simply presented, designed to inform the investor, not an overabundance of opaque facts, figures and words designed to satisfy lawyers and which, intentionally or not, mesmerize the investor.

Point-of-sale disclosure for example.  Here, to be honest, the historic and current state of affairs leaves a lot to be desired.  In my view, the average mutual fund prospectus is not intended to inform and enlighten investors in good faith, but rather to satisfy a statutory requirement for disclosure of material facts about the fund - rather like the lead paint disclosure document you get at a real estate settlement.  Only longer.  And with no pictures.  Moreover, investors generally don't see the prospectus until after the shares are bought and paid for.  And the SAI they rarely see at all.

I don't need to tell you that the average buy-and-hold mutual fund investor doesn't boast the financial sophistication of a Warren Buffet or a Carl Icahn.  He or she needs fund information disclosed in a way that is simple, intelligible and consistent from fund to fund for ease of comparison.  At the same time, it must not be inordinately burdensome to the selling broker, or as I said earlier, the broker will sell some competitive product.

The Task Force made what I believe is a quite workable recommendation - that prospective mutual fund investors be presented with a two-page document explaining in plain English all the material features of a fund - its investment strategies,  performance, average rate of return over the previous 10 years, costs passed on to shareholders, such as front-end loads and 12b-1 fees, and any conflicts of interest that may arise from the broker's relationship with the fund he or she is selling.

Most importantly, the disclosure document should spell out all the fees and expenses investors should expect to pay - be they transaction fees or fund operating expenses.

And all this information should be made available through the Internet to provide easy access.  Internet delivery makes side-by-side comparison of several funds easy and allows investors to drill down through hyperlinks to get more information.  In supplying investors with point-of-sale disclosure, one size definitely doesn't fit all.  Of course, we would certainly expect alternative forms of delivery - paper or scripts read over the telephone - would still be permitted, but Internet delivery has these great advantages.

I mentioned conflicts of interest, such as arise from revenue-sharing.  Certainly, a mutual fund company has a right to reward a broker-dealer for selling its funds rather than others.  And certainly, the broker-dealer has a right to pass those rewards on to its salespeople.  That's all fine, with one caveat: where such arrangements exist, the investor needs to know about them - before he or she buys the shares.

We don't propose that revenue-sharing agreements be explained in detail, only that their existence be noted.  For example, the point-of-sale disclosure document could offer yes-or-no answers to two basic questions:

  • Does the fund or its affiliates pay the broker-dealer more to promote its funds over others?
  • Does the broker-dealer pay its personnel more for selling this fund than for selling other funds the broker-dealer offers?

So informed, the investor can find out more by clicking on a hyperlink, such as the extent to which the revenue-sharing arrangement may have affected the selling broker's recommendation.

There is a proposed draft of this disclosure document on the SEC's website.  I encourage you to look at it.  The comment period is over, but I'm sure the SEC will consider expressions of support.

We don't think providing investors with a few simple, basic facts - facts they have every right to know - at the point of sale is an unfair or onerous requirement.  And, that is certainly the case if firms can deliver this information via the Internet.  Indeed, to relieve some of the cost and burden on firms, NASD is prepared to play a role in creating and maintaining an on-line database utility to host the point-of-sale documents for all mutual funds.  A firm could straightforwardly link to this utility, add as necessary the information particular to its firm, and provide the necessary disclosure of the point-of-sale documents.  NASD understands that regulation imposes costs, and we believe we have a responsibility to bear some of those costs.

We welcome and consider your input on all our proposals and positions, and we have made adjustments to some in response to your comments and suggestions.

The Task Force also offered some cogent recommendations on the use of soft dollars.

Principally, the Task Force believes that soft-dollar access to research - proprietary and third-party research - ought to be preserved, including the right to bypass the lowest available commission to obtain soft-dollar services.  The question is: what soft-dollar services are reasonable?  In many cases, this is no mystery.

Is substantive research, including third-party research, intended to improve the management of client accounts, an acceptable soft-dollar expenditure?  Of course.

Is provision of office space?  I think not.

Between these two ends of the spectrum you find a few uses of soft dollars that are not so easily defended or opposed.  Rather than going down the list and saying this practice is acceptable and this one isn't, the Task Force recommended that the SEC narrow the scope of the safe harbor provision to allow only research services that principally benefit investors, not advisers.

That would exclude material services such as computer hardware and software, phone and data transmission lines, newspapers and magazines and so on.  It would include services that have intellectual content.

The Task Force, which I chaired, also expressed its belief that soft-dollar practices and portfolio transaction costs ought to be better-disclosed, publicly, to mutual fund investors and, internally, to mutual fund boards.  With regard to soft-dollar practices, while the Mutual Fund Task Force didn't go this far, I personally would hope that mutual fund boards of directors would encourage brokers to unbundle the commissions they charge to make clear the cost of the actual transaction and the cost of the ancillary, permitted research services they provide.  Such information will help mutual fund boards decide whether the research services are worth the cost to their shareholders.

More than 80 percent of the firms we regulate are small firms - that is, they employ fewer than 150 registered reps.  They don't have in-house research staffs and, in many cases, they don't have the wherewithal to pay for research and the like with hard dollars.  So, I think it is vitally important that soft-dollar access to research, including third-party research, be preserved.  And I'm confident it will be.

The bottom line is this: if you accept the principle that the investor should be the foremost beneficiary of soft-dollar expenditures, and adhere to that principle, you'll get no quarrel from us.

And that is a principle you would do well to apply in everything you do professionally.

It was a failure to do so that led to our discovery in 2002 that a substantial proportion of high-dollar buyers of Class A mutual fund shares were not getting the front-end load discounts that they were owed.

And just as soft dollars have in some cases been used inadvertently for purposes that Congress didn't intend, volume discounts on A shares have in some cases been withheld inadvertently from investors.

As dissimilar as these two issues are, our responses to them are not dissimilar at all.  We can deal with both by making the processes more transparent to you and to your customers.  And in the area of breakpoints, we are well along the way to doing that.

Let me point out here that not all the breakpoint failures we discovered were unintentional and we have taken disciplinary action against a number of brokers and firms whose failures were negligent in the extreme.  And we'll continue to do so as circumstances warrant.

We also required all the firms we oversee to determine which of their clients had been deprived of discounts and to give them refunds as quickly as possible.

But our job is not simply to right wrongs and punish wrongdoers.  It is also to help the people and firms we regulate to avoid inadvertently becoming wrongdoers.  Investors are best protected if firms get it right the first time, and we believe in many cases we can help.

Mistakes can be particularly hard to avoid in the area of breakpoints, where determining a customer's eligibility for a discount almost requires a specialization in calculus.

It doesn't have to be that hard.  What the industry needs is a single, easily accessible source of information that brokers can turn to for all the information they need to determine customer eligibility for discounts - information such as breakpoint schedules, pricing methods and linkage rules.

In July 2003, the Joint NASD/Industry Task Force on Breakpoints, which we convened, recommended that the fund industry work with NSCC (the National Securities Clearing Corporation) to create such a database.

At this time, I'm pleased to say that NASD is putting the finishing touches on an easy-to-use Web site that will allow registered reps and investors to access key mutual fund discount and expense information right at their desktops. And, we're using a variety of approaches to monitor the data to ensure that it stays accurate and up-to-date.  We expect to launch the site in the next few weeks.  Let me emphasize that NASD is bearing the cost of this web site.  This is a proper role for us.

For this to work, though, the fund industry has to provide the requisite data, and ensure that it is kept current with the information in the funds' prospectuses.  I met with ICI's Board last May and strongly encouraged them to get the fund industry to work harder at this.  I told them that our board had authorized us to petition the SEC for a rule to require that funds provide the breakpoint data needed to make the Web site work.  The ICI responded - committing to an industry deadline of August 31 for larger fund families to provide their breakpoint information to NSCC.

As of today, most of the larger fund families have provided their breakpoint information.  But there are a number of funds, many of them smaller ones, that still have not.  To date, 66 fund families, representing over 90% of 2004 new front-end load fund sales, have posted information on breakpoint schedules and aggregation terms to the NSCC database.  We appreciate the hard work the funds have done to provide the requisite data, but there are still half the fund families selling load funds that have not yet supplied their data.  We expect full participation.

As I said, getting breakpoints right doesn't have to be hard.  The extraordinary advances in telecommunications of just the last decade or so have made all our lives easier, and in so many ways.  Thanks to the World Wide Web, information that used to take hours, days, weeks, even months to find and aggregate now is available in a matter of seconds.

The industry and the regulatory community have made a lot of progress in harnessing the power of the Internet to make the science of investing approachable to the uninitiated.  But there is a lot more to do in this regard, and I can hardly think of a better example than the disclosure regime for 529 college savings plans.

There are two issues here.  One is that Congress designated 529s as municipal securities, not as mutual funds, and thus gave the Municipal Securities Rulemaking Board authority to make the rules that govern their sales.  NASD is charged with enforcing those rules.

The other issue is that 50 states offer 529 plans to parents saving for their children's college education and no two of them disclose their costs, benefits and risks in exactly the same way.

To investors, 529 Plans look like mutual funds. And why shouldn't they?  They are mutual funds, with an added layer of state and federal tax benefits.  So, investors have every reason to expect that the sales practice rules for 529s will be comparable to those that NASD created to protect investors when they buy mutual funds.

Some time ago, we called for a change that would have the MSRB adopt our mutual fund sales rules and apply them to 529 sales.  And I'm happy to say that, working together, we've been able to get the MSRB to make the sales practice rules for 529s mirror those that protect investors in the sale of mutual funds for all our major rules.  We appreciate the cooperation we've gotten from the MSRB.  This is an excellent example of regulatory cooperation in the service of investors.

To make this partnership continue to work as seamlessly as possible, we would like today to call on the MSRB to enact a rule that automatically applies to 529s any future sales practice rules that NASD sets for mutual funds.  That would ensure investors that they will have as much protection from fraudulent and misleading sales practices when they buy 529s as when they buy mutual funds.  There would be no breakdown in the rule regimes and no delay in keeping them in harness.  Think of it as the regulatory equivalent of indexing tax rates to inflation, so that the rules automatically change as the world changes.

Of course, the MSRB could at any time decide to opt out of any mutual fund rule NASD adopts, and indeed could revoke the agreement at any time.  But putting the agreement in place and keeping it in place would give investors confidence that when they buy products that look the same to them, they will receive similar protection from sales practices abuse.

There's one more point I'd like to make about 529s.  The proposed rule on point-of-sale disclosure for mutual funds would apply to 529s as well.  But that doesn't negate the fact that 50 states offer 529s, and no two of them disclose basic information about them in the same fashion.

We have been saying for some time that this should not be the case, in part because it isn't necessarily in an investor's best interest to buy 529 plan shares offered by his state of residence.  The state issuers of 529 plans should, to the extent possible, standardize disclosure, so that investors can compare apples to apples.  And to that end, the National Association of State Treasurers and its affiliate, the College Savings Plan Network, last December proposed a set of disclosure principles and encouraged each state to adopt them voluntarily.

And the states have responded splendidly.  According to the MSRB, nearly all of them have either agreed to adopt the disclosure principles or are looking at them favorably. We hope and expect that soon, parents who want to put money away for their children's college education will be able to compare 529 plans with a minimum of confusion.

I talked at the outset about how the regulatory burden on brokers who sell mutual funds could encourage them toward products that are more lightly-regulated and, thus, easier to sell.  This is a trend that concerns me.  There are a couple of initiatives we can take to deal with it.

First, we can work hard to remove unnecessary burdens in the sale of mutual funds, as we are doing with our point-of-sale proposals.  And we can shoulder some of the related costs ourselves.  Second, we can assure that other, competitive products are subject to sales and disclosure regimes that are as comprehensive as those for mutual funds.

Investors clearly are not well-served by a race to the bottom.  Product recommendations that brokers make ought to be based, first and foremost, on the customers' needs and desires, not on how easy the products are to sell.   So, to level the playing field, I think we need to start looking at fixed annuities, variable annuities and equity-indexed annuities, exchange-traded funds and perhaps some other products, such as separately managed accounts, to ensure that investors are as well-protected from abuses when they buy those as they are when they buy mutual funds.

In the case of variable annuities, we have proposed a rule establishing specific suitability and supervision requirements.  And, in the case of equity-indexed annuities, we issued a Notice to Members in August suggesting that registered reps would do well to treat them as securities, even though it's not clear that they are in every case.

Harmonization of rules governing the sales of similar products is a matter of fundamental fairness.  Investors have a right to expect a level playing field when they're examining and comparing products that are close substitutes for each other.

I know that there is a perception within the industry that we, as regulators, live to regulate - that we get out of bed in the morning and say: what can we do today to make our members' lives more difficult?  I don't know how much good it does for me to say it isn't true.  But it isn't true.  Our passion is for protecting investors, not for regulation and enforcement.  And it is for that reason alone that we propose to balance the regulatory regimes for all investment products that are sold to mainstream investors.  We have tried hard to be conscious of the regulatory burdens and costs imposed by the regimes we propose - and indeed to shoulder some of those costs ourselves, as we have done with the mutual fund breakpoint database and would do with the mutual fund point-of-sale database.

I'm sure that many of you are anxious to debate this proposition with me, and it's only fair that I leave plenty of time for that.  I'm eager to hear what you have to say.

Before inviting your questions, though, I want to talk briefly about NASD's accomplishments over the last few years, as November will mark the five-year point of my tenure as CEO.

As I said a moment ago, NASD exists to protect investors.  And that entails, as you well know, a good bit of regulatory and enforcement activity, especially given all the bad behavior that has infected our industry in recent years.  Our communications people do a good job of trumpeting our successes at enforcing our rules and punishing malefactors, so I won't roll out the statistics on how tough we've been.

Comprehensive and effective investor protection entails a lot more than rule-writing and enforcement.  Investors can and should play a meaningful role in their own protection.  But they can only do so if they are well-informed about investing and the markets and have the right information on which to base their decisions.  Properly informed investors, trading in fully transparent markets, can be the front-line of investor protection, partnering with our regime of rule-writing and enforcement.

For these reasons, we have devoted a great deal of time and attention to the related missions of market transparency and investor education.

A few examples:

  • We have brought light to the previously dark world of corporate debt by launching the Trade Reporting and Compliance Engine or TRACE.  Trade and price information on corporate bonds used to be difficult, at best, for retail investors to find. Now it's simple and instantaneous.
  • For mainstream investors, choosing and working with a broker used to be almost entirely a matter of trust.  Trust still resides at the heart of that relationship, but now investors can turn as well to NASD Broker Check for information about a broker's background and disciplinary history, if any.  Using Broker Check, too, is simple and instantaneous.
  • In the past two years, we have poured $31 million into the NASD Investor Education Foundation, which will soon receive another $55 million from the SEC, thanks to a ruling by a federal judge on September 2nd.  The foundation has issued millions of dollars in grant funds for programs to educate and enlighten regular investors.  It has set aside $6 million for programs that specifically benefit members of the armed forces and their families.
  • And we've increased the urgency with which we warn investors about new and emerging issues and trends that may affect them.  Since the start of 2001, we've issued 30 Investor Alerts that inform people, in plain English, how they can protect themselves against booby traps like on-line identity theft and fake regulator websites - and teach them what they need to know about new offerings, such as 100 percent mortgages and funds of hedge funds.

As CEO, I am every bit as committed to these means of protecting investors as I am to our responsibility for making and enforcing rules.  The term "buyer beware" is an appropriate signpost.  Investors have a responsibility to enlighten themselves about securities before they buy them.  And we, as regulators, have a responsibility to provide them with the tools and information they need to invest with knowledge and confidence.

This is a responsibility we take very seriously.  We have addressed it - and will continue to address it - with great energy and sense of purpose.

With that, let me say thank you again to Don Kittell and the SIA for giving me the opportunity to be with you.  And now I'll be happy to answer any questions you may have.